Nivra 6 01

Trends in Valuation
NIVRA, Amsterdam, June 1, 2001
Tom Copeland
Managing Director, Monitor Corporate Finance
Monitor Group, Cambridge, Massachusetts
tom_copeland@monitor.com
www.corpfinonline.com
www.monitor.com
For more reading see:

Copeland, T, T. Koller, J. Murrin, Valuation: Measuring and Managing the Value of Companies
Copyright 2001 by Monitor Company Group, L.P.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means
electronic, mechanical, photocopying, recording, or otherwise without the permission of Monitor Company Group, L.P.
This document provides an outline of a presentation and is incomplete without the accompanying oral commentary and discussion.
COMPANY CONFIDENTIAL
Changes in Value are at the Heart of Economic Decision-Making

Discounted
DiscountedCash
CashFlow
FlowValuation
Valuation DCF
DCF
Expectations-Based Management
Real Options Analysis
ZKN-MFR-NIVRA 6 01-TEC
Copyright 2001 Monitor Company Group LP Confidential CAM
Discounted Cash Flow Definition
DCF has three components:

Free Cash Flow =
EBIT - Cash taxes on EBIT + accrued taxes due

+ depreciation Capital Expenditures operating working
capital
WACC =
Continuing Value =
B
S
K b (1 marginal tax rate) K S
V
V
EBIT (1 cash tax rate)(1 g / r )

WACC g
DCF Works Well For Large Publicly Held Companies
35 Large U.S. Companies, 1988

12.0
1999 Market / Book Value
10.0
1988 Market / Book
31 Large U.S. Companies, 1999
15
8.0
6.0
4.0
R2 = 0.94
2.0
10
R2 = 0.92
0
0.0
0
10
1988 DCF / Book
Source: Value Line forecasts; Copeland, Koller, Murrin, Valuation, 2nd edition, 1994
10
15
1999 DCF / Book Value
Source: Value Line Forecasts, Monitor Analysis

High Correlation Between Market Value and DCF Value

for 28 Japanese Companies 1993
The R2 for 28 Japanese companies was 89 percent
5
R2 = 0.89
Market /
Book
Value
0
0
DCF / Book (Using Value Line Forecasts)
Comments:
1. Underutilized land
2. Cross-holdings
Correlation between DCF and Market Value Italy

. . . for 15 Italian companies (the R2 was 95.4 percent) . . .
1.6
3.0
Correlation Between DCF and Market

Value
for 15 Italian Companies* 1990
Benetton
Cementir
1.4
2.0
1.2
Auschen
Fidenza
Merloni
1.0
Stet
Market /
Book
Value
0.8
Montedison
Fiat
Pirelli
0.6
Snia
Magneti M.
Burgo
Falk
Olivetti
Sip
0.4
R2 = 0.954
0.2
0.2
0.4
0.6
0.8
1.0
1.4
2.0
1.2
1.6
3.0
DCF / Book
* Using publicly available information

** Capitalization on September 28, 1990 (Borsa valori di Milano), book value of company
Source: Copeland, Koller and Murrin, Valuation
Comments:
1. Mark to market inflation accounting
2. Holder assets
Brazil
DCF Works Across Different Industries
13 Insurance Companies
16 banks
3
Market / Book Value
Market / Book Value
3.0
2.5
2.0
1.5
R2 = 0.97
1.0
0.5
R2 = 0.92
0.0
0
0.0
0.5
1.0
1.5
2.0
2.5
3.0
DCF / Book Value
1
2
DCF / Book Value
* 5 banks are non-U.S. banks

Source: Global Vantage; Value Line
1. Equity Approach
2. Income model/ interest spread model
1. Equity Approach
2. Unrealized capital gains
9
0
15-Jun-99
4-Jun-99
25-May-99
14-May-99
5-May-99
26-Apr-99
15-Apr-99
6-Apr-99
25-Mar-99
16-Mar-99
5-Mar-99
24-Feb-99
12-Feb-99
3-Feb-99
25-Jan-99
13-Jan-99
4-Jan-99
4-Aug-99
13-Aug-99
24-Aug-99
2-Sep-99
14-Sep-99
4-Aug-99
13-Aug-99
24-Aug-99
2-Sep-99
14-Sep-99
26-Jul-99
10
26-Jul-99
20
15-Jul-99
30
15-Jul-99
40
6-Jul-99
50
6-Jul-99
1999 Trading Volume (AOL)
24-Jun-99
60
24-Jun-99
15-Jun-99
4-Jun-99
25-May-99
14-May-99
5-May-99
26-Apr-99
15-Apr-99
6-Apr-99
25-Mar-99
16-Mar-99
5-Mar-99
24-Feb-99
12-Feb-99
3-Feb-99
25-Jan-99
Volume
(Millions)
13-Jan-99
4-Jan-99
DCF Works for Robust Growth Companies
180
1999 Stock Price (AOL)
160
140
Price Per
120
Share
100
80
60
Note: 1999 elsewhere in valuation refers to FY 99 which ends in June

Source: Compustat
AOL Revenue Assumptions for the Valuation Model Were Closely Tracked
to Analyst Estimates of Long Term Revenue Growth
Revenue Growth
$30,000
1999-2004 Average
Growth Rate: 25.4%
$27,450
2004-2009 Average
Growth Rate: 13.2%
$25,000
$25,183
$22,894
$20,000
$20,260
$17,466
$ Billions
$15,000
$14,801
$12,233
$10,000
$9,945
Long-Term Revenue Growth: 9%
$8,080
$5,000
$6,288
$4,777
$0
1999
Deviation from
Analyst
Projections*
2000
1.5%
2001
1.9%
2002
2.3%
2003
2004
2005
2006
2007
2008
2009
0.1%
* Most analysts did not forecast beyond 2003

Note:
FY for AOL ends in June
Source: ING Barings; BankBoston Robertson Stephens; Donaldson, Lufkin, and Jenrette
10
AOL Projected Operating Margins Benefit From Both Significant Scale

Economies and Changes in Revenue Mix Toward Higher Margin Businesses
Revenue Mix
100%
80%
10%
8%
7%
21%
25%
24%
7%
29%
7%
33%
7%
Enterprise
38%
Advertising
60%
Percent of
Revenue
Online Services
40%
70%
67%
69%
65%
60%
55%
20%
0%
1999
2001
2003
2005
2007
2009
Operating Margin
12.9%
22.0%
28.9%
32.1%
33.9%
34.8%
Analyst Projections*
13.1%
22.6%
28.1%
32.0%
* Average
11
AOL: Increasing Capital Productivity
Capital Expenditures and Capital Turns (Rev / Invested Capital)
$1,200
8
$1,043
CapEx
$1,000
$1,007
Capital Turns
$916
6
$810
$800
CapEx
$699
$592
$600
$409
$400
$404
$448
$489
Capital
Turns
$312
2
$200
$0
Analyst
Projections
(CapEx)*
0
1999
2000
2001
2002
$355
$375
$375
$375
2003
2004
2005
2006
2007
2008
2009
* Most analysts did not forecast beyond 2003

12
AOL: Matures Led to the Use of a Changing WACC

Based on comparables taken from telecom, software, and news media
AOL Capital Structure
100%
75%
Percent
99.7%
50%
92.5%
85.4%
Equity
14.6%
Debt
25%
0.3%
7.5%
0%
1999
2004
Equity Beta
1.69
1.38
1.06
Debt Rating
B1
BBB3
A3
15.6%
13.5%
11.0%
WACC
2009
Source: Compustat, Bloomberg, Monitor Analysis

13
AOL: Continuing Value
In the base case shown below, continuing value contributes 85% of total operating
value (approximately $76 out of $93 per share)
Continuing value growth rate has a particularly large impact because the growth rate is
very close to the ending WACC of 11%
Return on New Investment

Continuing Value
NOPLAT
Growth
35%
40%
45%
8%
$55,933
$58,038
$59,674
9%
$80,934
$84,474
$87,228
10%
$155,025
$162,820
$168,883
WACC = 11% in the long run
14
AOL: Metcalfs Law (Interconnectivity) Makes Scale a Sustainable

Competitive Advantage Leading to Perpetually High ROIC
Example:
People in
Network
2+1=3
3+ 2 + 1 = 6
4 + 3 + 2 + 1 = 10
5 + 4 + 3 + 2 + 1 = 15
Connections
(graph)
Number of
Connections
N2 - N
I=
2
Metcalfs Law:
AOL has 18 million customers 1.62 x 1014 connections

MSN has 2 million customers 2.00 x 1012 connections
AOL has roughly 10 times as many customers as MSN,

but roughly 100 times the number of connections
15
AOL: The Changing WACC and Continuing Value Assumptions Bridge

the Analyst Projections and the Current Market Value
AOL Entity and Equity Value

$120,000
84,481
102,496
2,688
(348)
$90,000
$MM
$93 per Share
$60,000
$30,000
15,694
$0
PV of FCF
1999-2009
PV of
Continuing
Value
Marketable
Securities and
Non-operating
Assets
Debt
Equity Value
Implied share price of $93 versus trading range of $89 to $104 between mid-August
and mid-September
16
AOL Market Ratios Decline Over Time as the Firm Matures
Price to Earning and Price to Book

160
140
138.7
123.3
120
P/E Ratio
100
89.5
80
71.3
55.4
60
40
47.2
33.9
26.6
22.8
20
19.1
15.5
41.9
38.1
12.7
10.6
9.0
7.8
2004
2005
2006
2007
P/B Ratio
0
1999
2000
2001
2002
2003
35.7
17
34.4 33.4
6.9
2008
6.2
2009
Amazon.com: Amazons Stock* (up to August 1999)
$200
$172
$172
$150
$125
$117
$107
Dollars
$124
$128
$119
$100
$100
$64
$50
$42
$37
$0
Sep-98
Oct-98
Nov-98
Dec-98
Jan-99
Feb-99
Mar-99
Apr-99
May-99 Jun-99
Jul-99
Aug-99
* On August 12, 1999 Amazon.com undertook a 2 for 1 stock split. As our valuation reflects the value of the
company in July 1999 we will use the number of outstanding shares before the split.
18
Monitors Valuation Results: Amazon.com (July 1999)
$20,000
$15,086
$361
$349
$16,447
$15,000
$101 per Share
$10,000
$5,000
$1,329
$0
PV of FCF
19982008
PV of
Continuing
Value
PV of
Marketable
Securities
and Nonoperating
Assets
Debt and
Retirementrelated
Liabilities
DCF
Estimate
of Equity
Value
Note: Valuation as of July 1999 reflects pre-split price of $101/share. Trading range was $126.50 to $97.50
19
Summary Operating Assumptions July 1999

Monitor
Revenue Growth
2000 50%
2001 39.2%
2002 onward 39.2% declining to 21%
COGS / Revenue
2000 77%
2001 76%
2002 74%
SG&A / Revenue
2000 28%
2001 22.4%
2002 15% declining to 10.5%
Capex / Revenue
2000 2%
2001 1.5%
2002 1.5%
Net Working Capital /

Revenue
2000 - 16%
2001 -17.5%
2002 - 17.5%
20
Amazon.com Revenue Assumptions Were Closely Tracked to Analyst

Estimates Except for Donaldson, Lufkin & Jenrette
$30,000
1999-2004 Average
Growth Rate: 40.5%
$25,000
2004-2009 Average
Growth Rate: 25.9%
$20,000
DL&J* Revenue
Forecast
Revenue
(In Millions) $15,000
$10,000
$5,000
Long-Term Revenue Growth: 9%
$0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
* Donaldson, Lufkin, and Jenrette

Note:
Most analysts did not forecast beyond 2003
21
Amazon.com: Sensitivity Analysis of Price Per Share

92% of the Amazons market value is realized after the year 2009 and is reflected in the
Continuous Value. The assumptions about the two parameters of Amazons Continuous
Value: NOPLAT Growth and Return on New Investment are key to its valuation.
Return on New Investment

Continuing Value
Sensitivity
NOPLAT
Growth
10%
11%
12%
9%
$66
$102
$132
8%
$66
$82
$95
7%
$66
$75
$83
WACC = 10% in the long run
22
Amazon.com
Company TSR vs. S&P 500, 1999-2000
1.8
1.6
1.4
S&P 500
1.2
TRS
0.8
0.6
Amazon
0.4
0.2
0
De
c98
Ja
n99
Fe
b99
Ma
r99
Ap
r99
Ma
y99
Ju
n99
J
ul99
Au
g99
Se
p99
Oc
t99
No
v99
De
c99
23
Ja
n00
Fe
b00
Ma
r00
Ap
r00
Ma
y00
Ju
n00
J
ul00
Au
g00
Se
p00
Oc
t00
No
v00
De
c00
Ja
n01
Amazon.com: Valuation Results July 1999 vs. January 2001

Value Build-Up January 2001
Value Build-Up July 1999

$101 per Share
$20,000
$ 15.3 per
share
$ Million
$15,086
$349
$361
$16,447
9000
$15,000
8000
$1,045
7000
$5,373
6000
$10,000
$2,114
$5,433
5000
4000
$5,000
3000
2000
$1,329
$1,130
1000
$0
PV of
FCF
19982008
PV of
Contin
uing
Value
PV of
Marketable
Securities
and Nonoperating
Assets
Debt and
Retirementrelated
Liabilities
DCF
Estimate
of Equity
Value
PV of FCF 2000 PV of
PV of Excess Total Debt DCF Estimate of
2009
Continuing Cash and NonEquity Value
Value
Operating
Assets
Note: Valuation as of July 1999 reflects pre-split price of $101/share.

Trading range was $126.50 to $97.50
24
Amazon.com: Operating Assumptions

1997 1999
Jefferies
Merrill Lynch
Bernstein
Monitor
Monitor
January 01
July 99
2000 70.5%
2000 67.7% 2000 67.7% 2000 67.7% 2000 68.7%
2000 50%
2001 43.1%
2001 29.2% 2001 35%
2001 39.2%
2002 38.7%
2002 20%
History
Revenue
Growth
COGS /
Revenue
SG&A /
Revenue
Capex /
Revenue
Net
Working
Capital /
Revenue
Avg 440%
Robertson
Stephens
2001 36.4% 2001 38.2%

2002 30%
2002 onward
29.6% declining
to 17.5%
2002 onward
39.2%
declining to
21%
Avg 78.2%
2000 74%
2000 75.2% 2000 75.2% 2000 75.2% 2000 74.5%
2000 77%
1998 76.5%
2001 74.2%
2001 75%
2001 76%
1999 80%
2002 73.8%
Avg 37.5%
2000 37.4%
2000 35.1% 2000 35.1% 2000 35.1% 2000 35.6%
2000 28%
1998 32.1%
2001 29%
2001 22.4%
1999 41.1%
2002 23.3%
2001 27.2% 2001 29.2% 2001 27.5% 2001 28.2%

2002 23.5% 2002 23.4%
declining to
20.2%
Avg 10.1%
2000 4.5%
2000 10.3%
2000 7.4%
2000 2%
1998 5%
2001 3.1%
2001 1.6%
2001 2.4%
2001 1.5%
1999 19.8%
2002 2.3%
2002 0.9%
2002 1.6%
2002 1.5%
Avg -19.3%
2000 -18.8%
2000 - 16.8%
2000 - 16%
1998 -16%
2001 -12.5%
2001 -10.5%
2001 -17.5%
1999 -23.5% 2002 -13.2%
2002 - 12.7%
2002 - 17.5%
2001 75.5% 2001 76%
2001 74.9%
2002 74.1% 2002 73.6%
25
2002 74%
2002 15%
declining to
10.5%
Amazon.com: WACC & Continuing Value Assumptions

Monitor Assumptions
January 2001
Monitor Assumptions
July 1999
WACC
Barra Beta
2.09
1.91
Risk Free Rate
5.3%
6.3%
Credit Rating
Pre-tax Cost of Debt
10.9% (Debt / Total Capital

(market value) 21.7%)
11.8% (Debt / Total Capital

Cost of Equity
16.8% (Equity / Total Capital

16.8% (Equity / Total Capital

WACC
14.5% declining to 10% by 2009
16.6% declining to 10% by 2009
Growth in NOPLAT
9%
9%
Return on Net New

Investments
11%
11%
Continuing Value
26
Discounted Cash Flow Valuation DCF
27
An Example:
Performance Measurement
Most traditional performance metrics create perverse incentives to management. Only
Rational Expectations focuses on shareholder value creation
Metric
Critique
Sales Growth
Ignores profitability, ignores balance sheet
EPS
Ignores balance sheet
EPS Growth
Ignores balance sheet
ROIC = EBIT / Invested Capital
Encourages harvesting behavior
ROIC-WACC*
Encourages harvesting
EVA=(ROIC-WACC) x Invested Capital
Not correlated with TRS
Rational Expectations
Best of short-term metrics
28
Which Company Did Better?

Sears vs. Wal-Mart
A good example is found in the comparison between Wal-Mart and Sears over the 1994
1997 four-year interval. Can you tell from the data below which company had superior total
return to shareholders?
Sears**
Wal-Mart
1994
1995
1996
1997
CAGR
1994
1995
1996
1997
CAGR
Sales Revenue
(billions)
$54.6
$34.9
$38.2
$41.3
-8.9%
$82.5
$93.6
$104.9
$118.0
12.7%
EBIT (billions)
$3.4
$3.1
$3.5
$3.9
4.7%
$3.6
$4.1
$4.1
$4.4
6.9%
Net Income (billions)***
$1.2
$1.0
$1.3
$1.2
0.0%
$2.6
$2.7
$3.1
$3.5
10.4%
ROIC
19.5%
-5.3%
-4.2%
-5.2%
10.4%
8.9%
8.9%
9.8%
WACC
9.1%
7.3%
8.1%
7.5%
12.5%
10.0%
11.0%
10.6%
ROIC-WACC
10.4%
-12.6%
-12.3%
-12.7%
-2.1%
-1.1%
-2.1%
-0.8%
Invested Capital
(billions)
$21.66
$28.20
$30.19
$34.22
16.5%
$29.84
$33.54
$34.56
$36.60
7.0%
Economic Profit
(billions)
$2.24
-$3.56
-$3.72
-$4.33
-$0.63
-$0.36
-$0.73
-$0.28
-5.80
-0.16
-0.61
0.27
-0.37
0.45
Change in EP
(billions)
* Sears destroyed on aggregate of $9.37 billion while Wal-Mart destroyed $2.00 billion
** Excludes Allstate
*** Before extraordinary items
29
Between January 1994 and December 1997 the Total Return to Shareholders of
Sears Was Consistently Higher Than the Total Return to Shareholders of Wal-mart
Total Returns to Shareholders

Sears vs. Wal-Mart, 19941997
3.0
Sears Index
Wal-Mart Index
2.5
2.0
1.5
1.0
0.5
9/
97
7/
97
5/
97
3/
97
1/
97
11
/9
6
9/
96
7/
96
5/
96
3/
96
1/
96
11
/9
5
9/
95
7/
95
5/
95
3/
95
1/
95
11
/9
4
9/
94
7/
94
5/
94
3/
94
1/
94
0.0
Total Return
30
A Search of News Articles Provides a Clear Message That Sears Repeatedly

Exceeded the Markets Expectations While Wal-Mart Met or Fell Short of Expectations
Quotations
Sears
7/18/97 Excluding unusual items, yesterdays earnings report signals that the four-year
old rebound at Sears stores is continuing . . . The better-than-expected results
prompted several analysts to raise their Sears earnings forecasts.
Wal-Mart
11/18/96 They gradually recognize that the gap between expected and reported
earnings has narrowed. Wal-Marts earnings fell off the table and its stock
never fell way down. It just stopped going up as investors rotated into other
types of names.
5/17/94 Wal-Mart Stores Inc.s earnings soared in its first fiscal quarter while profit
sank at Kmart Corp. Analysts had expected Wal-Mart to perform a bit better. .
. . In Big Board composite trading yesterday, Wal-Mart shares fell $1.25 a
share to close at $22.75.
31
Changes in Analyst Expectations Match Chevrons TSR

During 1995, Chevrons earnings rose, but shareholder return was negative. Why?
Because during the year market expectations declined
Chevron Corp
Market-Adjusted TSR vs. Analyst Earnings Estimates, 1991-1998
1.4
1997
4.5
EPS
1.2
1
1996
0.8
1993
3.5
0.6
3
1995
2.5
1998
0.4
1994
Note: EPS and analyst expectations

exclude extraordinary items
1992
1991
0.2
32
Drop in
Analyst
Expectations
Positive
Earnings
Growth
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
Jul-95
Jan-95
Jul-94
Jan-94
Jul-93
Jan-93
Jul-92
Jan-92
Jul-91
Jan-91
Jul-90
0
Jan-90
1.5
Negative
shareholder
return
Market-Adjusted TSR
5.5
Analyst Expectations of Coca-Cola EPS, 19951998: The Asian Crisis

Analysts expectations of Coca Cola remained fairly constant during 1995 and 1996. However,
falling expectations during 1997 and 1998 resulted in below market stock performance
Earnings per Share 2.0
(adjusted for splits)
Expectations for Current Year (1 Year Ahead)

Expectations for Next Year (2 Years Ahead)
Actual Earnings Reported (Annual)
1.9
2 Years Ahead
1.8
1.7
2 Years Ahead
1 Year Ahead
1.67
1.6
1 Year Ahead
1.5
2 Years Ahead
1.4
1 Year Ahead
1.41
1.3
1 Year Ahead
1.2
1.18
1.1
1.0
Number of Analysts:
25
27
1995
25
22
22
1996
20
20
1997
19
1998
Source: IBES, Monitor Analysis

33
. . . And Its Total Return to Shareholders Relative to the Market

Coca-Cola Total Return to Shareholders Relative to the Market 19951998
Expectations Revised
Downward
1.4
1.2
1.0
0.8
0.6
34
Jul-98
May-98
Mar-98
Jan-98
Nov-97
Sep-97
Jul-97
May-97
Mar-97
Jan-97
Nov-96
Sep-96
Jul-96
May-96
Mar-96
Jan-96
Nov-95
Sep-95
Jul-95
May-95
Mar-95
Jan-95
0.4
Total Shareholder Return (TSR) Regression Results*

Traditional Performance Measures
Traditional performance metrics like EPS and EVA are very poor predictors of returns to
shareholders
Number of
Observations
Adjusted Rsquared
Basic EPS (Scaled by Lagged Share Price)
2,522
4.5 %
Change in Basic EPS
2,522
5.1%
EVA (Scaled by Lagged Market Value)
2,182
0.3 %
Change in EVA
2,182
3.0 %
Performance Measure
*The dependent variable for all regressions is market-adjusted TSR. Sample includes S&P 500 firms during 199298
35
Multiple Regression Results*

Multiple regressions of market-adjusted total shareholder return (TSR) vs. changes in
analyst earnings (EPS) expectations indicate a strong correlation between expectations
and returns
Variable Representing
Changes in Analyst
Expectations
Regression Coefficients
(T-Statistics in Parentheses)
Percent Change in Analyst

Forecasts of Current Year's
Earnings (EPS)
-0.01
(-0.34)
Percent Change in Analyst

Forecasts of Next Year's
Earnings (EPS)
0.70
(21.3)
Change in Analyst Forecasts

of Long-Term (35 year)
EPS Growth
8.6
(12.9)
Adjusted-R2
41.6%
Expectations about current

earnings have no significant
impact on TSR
Expectations about next year and

long-term earnings have
significant impact on TSR
Correlation is much higher than

traditional metrics (EPS, EVA)
* S&P 500 firms during 199298. Sample has 2,390 observations

36
Two Examples
Which business unit did better?

Actual ROIC 200x
WACC
Business A
30%
10%
Business B
5%
10%
Two projects are expected to earn 40% each and the cost of capital is 10%
Market Expected
ROIC 200x
Managements Revised
Expectations 200x
Project X
40%
40%
Project Y
40%
20%
37
Should we invest?
The Complete Picture

Value-Based Management:
Economic Profit = (ROIC-WACC) x Invested Capital
Expectations-Based Management:
EP =
[Actual ROIC Expected ROIC] x Invested Capital Work Core Assets Harder
[Actual WACC Expected WACC] x invested Capital Lower Cost of Capital
+ [ROIC WACC] x [Actual IC Expected IC] Invest Profitably
38
EBM
Together, DCF, EP, and value drivers form an integrated framework for value creation. DCF
is comprehensive, long-term based, EP is a comprehensive, short-term measure, and value
drivers are specific, short-term measures
Integrated Framework for Expectations-Based Management
Operating Value
Drivers, e.g.,
Cycle time
Customer
retention rate
Churn rate
Non-performing
loan rate
Used by all levels of

organization to set
goals and measure
performance; used for
benchmarking and
sensitivity analysis
Drives
Actual vs.
Expected
Annual Economic
Profit
Summed
Over
Time
Measures short-term
overall performance
by business
~
~
DCF Value
Shareholder Value
Value and compare

strategies; measure
long-term trade-offs
39
Implications
Need to set expectations correctly with:

Analysts, and shareholders
Internal management team
Need to exceed expectations to have TRS exceed cost of equity
TRS = Cost of equity

+ Unexpected company performance
+ Unexpected market movements
Take all new investments that are expected to have ROIC > WACC
Avoid the expectations treadmill with a two part incentive design
Total Compensation = Salary + Bonus

Salaryt = f (Financial Performance in year t-1)
Bonust = f (Exceeding Expectations for year t )
40
Discounted Cash Flow Valuation DCF
41
Simple Investment Decision Introduction

Consider the net present value approach to the following simple investment. When the
expected cash flows are discounted at the cost of capital, the NPV is $600 and the decision
is to invest. However . . .
Illustrative
Facts:
Investment outlay = $1,600
Once made, the investment is irreversible
Replacement expense equals depreciation
Perpetual level cash inflows
Price level = $200 now
50 / 50 chance of price changing to $300 or $100 in one year
The price will stay at its new level forever
Cost of capital = 10%

NPV = -1600 +
t=0
200
(1.1)t
= -1600 + 2200
= 600
Source: Dixit and Pindyck in Investment Under Uncertainty, Princeton University Press, 1994
42
The Investment Decision as a Deferral Option

. . . We have made an implicit assumption. We do not have to invest immediately, we can
defer. If the project is deferred one year, it is possible to take advantage of price
information. We would invest only if the price goes up. Regardless of whether it goes up
or down, the NPV with deferral is $733 today
-1600
1.1
NPV = .5
t=1
-1600 + 3300
1.1
= .5
1700
1.1
= .5
850
1.1
300
(1.1)t
+ .5
+ .5
+ .5
-1600
+
1.1
t=1
100
(1.1)t
-1600 + 1100
1.1
Do not invest if
price falls to
$100
[0]
= $733
Conclusion: Since the NPV of deferring is $133 higher than investing immediately,
we would choose to defer, even though the NPV of investing immediately is large and positive
43
The Value of a Deferral Option Increases with Variance

The value of deferral is a call option that is exercised when the irreversible investment is
undertaken. The value of this option is affected by variance of prices (or costs), by the level
of prices, by the scale of investment, by the level (and variance) of interest rates, and by the
length of time that the deferral option lasts
Suppose the price in the previous example is equally likely to go to $400 or $0 (rather than $300 or
$100)
NPV = .5
= .5
= .5
1400
1.1
-1600
1.1
t=1
-1600 + 4400
1.1
2800
1.1
400
(1.1)t
+ .5
+ .5
+ .5
-1600
1.1
t=1
0
(1.1)t
-1600 + 0
1.1
[0]
Do not invest if
price falls to $0
= $1,273
Conclusion: The value of the deferral option goes up as there is greater uncertainty
Possible Macroeconomic Implication: Greater uncertainty in the economy (e.g., due to political
unrest; uncertainty about taxes, interest rates or inflation) can cut investment because the deferral
option becomes more valuable
44
An Option Definition
In environments with high uncertainty and room for managerial flexibility investments will
have considerable option (strategic) value, which needs to be considered
An option:
Is the right but not the obligation to take an action (at a cost, called the exercise
price) for a predetermined period of time (called the maturity of the option).
Options capture the element of flexibility in decision-making
Financial Option
Real Option
The option is contingent

on the uncertain value of
a financial security, e.g.,
a CBOE call on a stock
The option is contingent

on the uncertain value of
a real asset, e.g., an
irreversible investment
opportunity in a new
project
A Side Bet
45
Management
Can Affect the
Value of the
Underlying Real
Asset
Identifying Options An Example of a Simple Option

Consider a situation where you can put $1.00 into a gray box and get $1.05 back after a
year with absolute certainty. Current interest rates are ten percent. How much is the gray
box worth?
$1.00
$1.05
Wrong Answer
NPV No
Flexibility
Right Answer
Total Value
with Flexibility
(ROA)
The gray box is worthless because you can earn 10% by putting
your money in the bank instead of earning 5% with the gray box
(Problem: this assumes that the interest rate never changes)
The gray box is valuable because it is an option (you have the right,
but not the obligation, to use it) and because interest rates are
uncertain. There is a chance that the rate will fall below 5%. When
it does, the option is valuable and will be exercised (the uncertainty
in the interest rate is the key to understanding the problem)
NPV is misleading because it does not consider the option / flexibility value this box offers
Source: Steve Ross, Sterling Professor of Economics and Finance at Yale University
46
When is Managerial Flexibility Valuable?

The flexibility value comes from the ability to respond to information that may be received in
the future. The greater the likelihood that this new future information will elicit a managerial
response and alter the course of a project, the more value the option will have
Low Likelihood of Receiving New Information
High
Uncertainty
Room for
Managerial Flexibility
Ability to respond
High
Moderate
Flexibility Value
High
Flexibility Value
1. High uncertainty about the future

Very likely to receive new
information over time
2. High room for managerial flexibility
Allows management to respond
appropriately to this new
information
+
Low
Flexibility Value
Moderate
Flexibility Value
Low
In every scenario flexibility value is greatest when the

projects value without flexibility is close to break even
Flexibility Value Greatest When:
47
3. NPV without flexibility near zero

If a project is neither obviously
good nor obviously bad, flexibility
to change course is more likely
to be used and therefore is more
valuable
Under these conditions, the difference

between ROA and other decision tools
is substantial
Applicability Progress to Date

The complication is that although real options are valuable, up to now option valuation has
been an esoteric subject accessible only to those trained in stochastic calculus and other
advanced mathematics. Recent advances in theory and technology, however, have
allowed us to implement option pricing capability in simple algebraic formulas in Excel
spreadsheets. Moreover, we can now handle more complicated situations when there are
multiple sources of uncertainty that are not necessarily traded world commodities
From
To
Uncertainty driven by world commodity

product
Source of uncertainty not necessarily

market priced
Higher mathematics necessary for

application
Algebra and Excel spreadsheets
Multiple sources of uncertainty

(rainbow options)
Options on options (compound options,

learning options)
Many applications
Single source of uncertainty
Simple options
Limited application
48
American Call Deferral Option

Coal Lease Valuation
This first example is a simple deferral option on the development of a coal lease for up to
five years after the lease was acquired
125
$116
Comments
100

price of coal
NPV approach ignored flexibility
Option was particularly valuable

because it was near-the-money*
(options on deep in-the-money
situations are not worth much
because you invest immediately)
$57
$72
75
Dollars
(Millions)
$59
50
25
0
NPV Valuation (No
Flexibility)
Successful Bid
Option Value with

Deferral
* The price of coal was close to the cost of extraction

49
American Put Cancelable Operating Lease

The Value of Cancelable Operating Leases on Aircraft
It was possible to value cancelable operating leases because there is a relatively active
market in second hand aircraft
Wide-Body Aircraft
25%
3%
20%
25%
83%
Walk-Away
Option
Total
19%
16%
Percent of
Engine
Price
Narrow Body Aircraft
90%
60%
15%
58%
Percent of
Engine
Price
10%
30%
5%
0%
0%
Pre-Delivery
Put Option
Walk-Away
Option
Total
Pre-Delivery
Put Option
Comments
Single source of uncertainty price of second hand aircraft
Option value significantly underestimated by management
Leasing strategy changed

50
Switching Option
The Value of Switching Options in Mining
Switching options apply to any situation where it is possible to shut down then reopen an
operation
1,500
Comments
$1,160
1,000
Study provided insight into when

to open up and shut down
operations
Value depended on the quantity

of mineral in the ground,
extraction costs, and the fixed
cost of startup or shutdown, in
addition to the usual list of
variables
Flexibility
Value
Dollars
(Millions)
$710
500
$447
0
Initial NPV Estimate
Scenario Based
NPV
Total
51
Switching Option
Exit and Reentry Decision
Despite the strong growth, consumer PC assembly players have found their market
participation to be mostly dissatisfying as they are not earning their cost of capital
Consumer Markets
Beverages
Consumer PC Assembly
12.5%
Commercial IT
Gateway
29.7%
11.0%
Acer
Sports Shoes
-2.0%
8.2%
Compaq
Consumer
Electronics
-4.1%
-1.5%
Apple
Automobiles
Consumer PC
Assembly
-7.0%
-2.3%
Packard Bell
-6.0%
-10%
0%
10%
-11.0%
-20%
20%
Spread: ROICWACC
0%
20%
40%
Spread: ROICWACC
Source: Analyst Reports; Annual Statements

52
ROA Gives Different Decisions Than NPV and Economic Profit

Traditional valuation techniques give mixed decisions about whether the unprofitable
players should immediately exit the business. However, ROA suggests that players should
stay in the market and exit only if conditions do not improve
Valuation Methodologies
ROV
NPV
Economic Profit
(WACC = 13.7%)
In Operation, Gross Margin = 13%
Continue
Continue
Exit (ROIC = 7.6%)
In Operation, Gross Margin = 11%
Continue
Exit
Exit (ROIC = 5.6%)
Scenario
Not in Operation
Dont Enter Dont Enter
53
Dont Enter (ROIC = 7.6%)
ROA Gives Different Values* of Staying in Business than NPV and EP

ROA gives significantly different value to the business than EP and NPV approaches
(1997, $Billions)
Valuation Methodologies
Economic Profit
(Short Term)
(ROICWACC) x IC
Gross Operating Margin
ROA
NPV + Flexibility
Value
15%
$2.98
$2.62
$0.05
13%
$1.71
$1.02
-$0.07**
11%
$0.79
-$0.59
-$0.09
9%
$0.36
-$1.79
-$0.11
NPV
(Cash Flows)
* Assume a volatility of 16% annually for the gross operating margin (GOM)
** ROIC before taxes = 7.6%, tax rate = 30%, WACC = 13.7%, invested capital is 26% of sales of $3.6 billion
54
Compound Option Multiphase investment

The Value of Compound Options in Plant Construction
Today (year 0), management does not need to commit to the entire project; it can simply
begin the design process (at a cost of $50 million) and learn more about the operating
spread uncertainty. Six months later, management has a similar option, to begin the preconstruction process without a full commitment and learn more about the uncertainties. At
the end of the year, management no longer has the flexibility to learn more about the
uncertainty and must choose between a full commitment or abandonment
Year 0
Six Months
Invest $50 million for design

process only
Full commitment no flexibility
End of Year 1
Invest $200 million only to start

pre-construction work
Full commitment invest $400

million
Full commitment no flexibility
Abandon
Uncertainty evolves but we

cannot react
Eliminated managerial
flexibility, and therefore
destroyed option value
Abandon no flexibility
Uncertainty evolves but we

cannot react
Eliminated managerial
flexibility, and therefore
destroyed option value
Abandon no flexibility
Decision Node
55
The Source of Uncertainty

At first there seems to be two sources of uncertainty: the price of the output per ton, and
the cost of the input per ton. However, these can be combined into a single source of
uncertainty, the operating spread
Estimated Data
Operating Spread = Output Price / Ton Input

1,400
1,200
1,000
Output Price
800
600
400
Input Price
200
0
1Q79 4Q79 2Q81 1Q81 1Q82 3Q83 2Q84 1Q85 4Q85 3Q86 2Q87 1Q88 4Q88 3Q89 2Q90 1Q91 4Q91 3Q92 2Q93 1Q94 4Q94 3Q95 2Q96 4Q96
Price History First Quarter 1979 to Fourth Quarter 1996

56
Summary Phased Investment

The traditional NPV approach dramatically undervalues this investment since it does not
consider the value of flexibility. Since this is a multi-staged investment, management has
the flexibility to re-evaluate the project at each stage and refine their strategy based on new
information. A full commitment (to either accept or abandon) eliminates managerial
flexibility and destroys the option (flexibility) value
$ Millions
$425.7
$354.5
- $71.2
NPV Valuation: No
Flexibility
Flexibility Value
57
Total Value (ROA)

Compound Rainbow Option

Exploration and Development
The decision tree below shows a stylized version of the decision to develop a large energy
resource. There were two sources of uncertainty, the price of energy and the amount of
resource in the ground, and there were compound options
Add capacity
in Year 11?
Planned capacity** plus 50%
Illustrative
Planned capacity
11
Assumed decision nodes
50% of planned capacity

Abandon
Lock in
capacity
now
What capacity
level to lock
into today?
Planned capacity*
11
Initial capacity decision
Year 3 initial capacity decision
11 Year 11 capacity addition decision

Abandon
Planned capacity**
+ 50%
Do not explore in
the near term
What capacity to
lock-in in Year 3?
11
95
Lock in capacity
today or defer
decision until Year 3?
Planned
11
Event nodes (uncertain outcomes)

Prices go up or down?
Reserves in existing fields are
higher or lower than EV?
Resource quantity found in 4
add-on fields worth developing or
not?
Planned capacity
50% of planned capacity
Abandon
11
Abandon
Exploration decision
11
OPM Cases
Defer
capacity
decision
How much to invest in

exploration during Year 1
through Year 3?
$ High
Explore in the interim?

3
(Year 1-Year 3)
Planned + 50%
11
Planned
11
Abandon
Explore
Planned + 50%
2
Capacity lock-in
Defer capacity decision and exploration
Defer capacity decision / explore today
11
$ Low
Planned
11
11
Abandon
11
* Simplified for illustrative purposes

** Capacity planned before ROA analysis
58
ROA Model Valuation Results*

The optimal solution provided more than twice the value and was completely different from
the clients base case
OPM Case
A.
Initial Capacity
Decision
Today
(planned
capacity)
No-options base case
Capacity
"lock-in"
B.
Exploration
Decision
Today
(No exploration)
Today (planned
capacity +50%)
Year 6
Defer capacity
decision and
exploration
Year 3
Year 6
Defer capacity
decision /
explore today
Year 3
C.
Add-on Capacity
Decision
Total Project Value Estimates**
Today
(No exploration)
Value of
Better capacity
lock in decision
Exploration option
Expansion option
100
150
Year 11
Value of price
information
200
Year 11
+
Value of reserve
size information
Today
Explore
225
Year 11
100
200
Normalized Currency Units
Most attractive operating plan
* Throughout the document the results have been normalized and rounded off to provide general insights while maintaining client confidentiality
** For comparison purposes and because of lack of information, each of the 4 cases assume a Year 1 exploration cost equal to 0; if best-guess exploration
cost of estimates of 40 is used, the NPV for the 3 option cases are 120, 175, and 185, respectively
Analogous to traditional DCF case (i.e., assumes deterministic inputs and no managerial flexibility)
59
Classic Questions and Their Answers

1. Option values are contingent on the current value and the expected volatility of the
underlying security or asset. If one holds a call option on a share of stock, the market
price is observable and we can estimate the expected volatility. But a real option is
contingent on an asset that is not traded in a capital market (e.g., a cure for baldness).
What do we do?
Marketed Asset Disclaimer (MAD): We assume that the present value of the asset
without flexibility is the same as the market price for which the underlying asset (without
flexibility) can be bought or sold
2. Lattices (Binomial tress in particular) are a discrete approach to modeling the GaussWiener continuous scholastic process that Black-Scholes assumed for the underlying
security when they derived the closed-form solution For European call options. But,
project cash flows do not follow, or even roughly approximate a regularized binomial
lattice
Properly Anticipated Process Fluctuate Randomly (PAP): Paul Samuelson proved
that the bid of any pattern of the future cash flows contains all expectations and
therefore moves randomly through time (obeying a Gauss-Wiener Process), deviating
only with unexpected changes in the problem of cash flows
60
A Four-Step Process
Free Cash Flows
Step One
40
30
Complete the base case present value

(without flexibility) based on
Expected future free cash flows
Cost of capital based on
comparables
20
20
20
10
PV
10
Free Cash
Flow
Year
-10
WACC = 10%
-20
Value
Cash Out
Note that the expected value of the project

evolves through time as shown in the figure
to the right
Evolution of
Project Value
Cash In
PV
Step Two
Estimate the volatility of the value of

the project in order to derive the
volatility of the rate of return
A Monte Carlo approach can
combine many uncertainties
The volatility of the drivers of
uncertainty may be estimated from
internal data or from subjective
estimates made by management
The output is a binomial lattice in value
u =e
8 Year
The Year Spread Sheet
Price
Quantity
Free Cash Flows

12...
. . . 10 CV
Monte Carlo
Simulation
Variable Cost
Interest Rates
n (V1 / V0) =
Value (t = 1)
r
u2V
uV
V0
duV
dV
d2V
T , d =1 / u
61
u3V
u2dV
d2uV
Event Tree
(Sans
Dividends)
d3V
Four Step Process (cont.)
Step Three
Put decisions into the nodes of the

event tree
Can have multiple decisions per
node
Payouts may include cash flows as
dividends
Expand, Contract
Expand, Abandon
Go, Stop
Expand, Contract
Expand, Abandon
Expand, Abandon
Step Four
Work backward in the tree (unless

there is path dependency) to obtain
values at each node and to make
optimal decisions
Use no arbitrage condition to
conform to law of one price
Output is the value of the project
with flexibility and decision rules
ROA1
Go
ROA0
Go
ROA2
Go
ROA1
Abandon
62
ROA2
Expand
ROA2
Abandon
Project Analysis
Overall Approach A Four Step Process
Compute Base Case

Present Value without
Flexibility Using DCF
Valuation Model
Steps
Objectives
Compute base case

present value without
flexibility at t = 0
Comments
Output
Projects PV without
flexibility
Identify and
Incorporate Managerial
Flexibilities Creating a
Decision Tree
Model the
Uncertainty
Using Event Trees
Calculate Real
Option Value (ROA)
Identify major
uncertainties in each
stage
Understand how those
uncertainties affect the PV
Analyze the event tree

to identify and
incorporate
managerial flexibility to
respond to new
information
Value the total project

using a simple algebraic
methodology
Still no flexibility; this

value should equal the
value from Step 1
Explicitly estimate
uncertainty
Incorporating flexibility
transforms event trees,
which transforms them
into decision trees
The flexibility
continuously alters the
risk characteristics of
the project, and hence
the cost of capital
ROA includes the base

case present value without
flexibility plus the option
(flexibility) value
Under high uncertainty
and managerial
flexibility option value
will be substantial
Detailed event tree

capturing the possible
present values of the
project
A detailed scenario tree

combining possible
events and
management
responses
ROA of the project and

optimal contingent plan for
the available real options
63
Step 4 Valuation Using the No Arbitrage Condition

Using the traded twin security we can value our project in year 0 using either the traditional cost of
capital approach, or the replicating portfolio method. Under the cost of capital approach we calculate the
expected rate of return using the twin and then discount the cash flows from our project at this rate*.
Alternatively, we can calculate how many shares (N) of the twin security would replicate the cash flow of
our project** in any state, and calculate the value of those shares in year 0 (N shares x price / share).
These two methods will yield the same result since the cost of capital approach is essentially a shortcut
for the replicating portfolio method***
Year 0
Twin
Security
Our
Project
P0 = 20
V0 = ?
Year 1
Calculating V0
Twin
Security
Our
Project
$34
$170
Twin
Security
Our
Project
$13
$65
Method 1:
Cost of Capital Approach
Method 2:
Replicating Portfolio**
1. Calculate cost of capital

using twin security
20 = (0.5)(34)+(0.5)(13)
1+k
k = 17.5%
1. Replicating cash flows

of our security using a
portfolio of twin and
borrowing in year 1
34N + B = 170
13N + B = 65
N = 5; B = 0
2. Value of this portfolio in
year 0
V0 = 20N + B
V0 = 100
2. Discount expected cash

flows
V0 = (0.5)(170)+(0.5)(65)
1.175
V0 = 100
* Since the twin security is a traded security with the same risk characteristics as our project (by definition), its required rate of return (discount rate)
must be equal to the discount rate on our project. CAPM simply generalizes this by claiming all securities with the same Beta (systematic risk) will
have the same cost of capital (if all equity financing); therefore, identifying a securitys Beta is equivalent to finding a priced twin security
** Typically the replicating portfolio will be a leveraged position that will also entail borrowing
*** Since the project and this portfolio provide the same future returns, to avoid risk-free arbitrage they must have the same value in year 0
64
NPV / DCF Valuation Flexibility Not Valued

Using the NPV / DCF methodology, this project would be rejected since it has a negative
NPV of -$6.5
Year 0
Year 1
Cash Flows
Investment
170
-115
Value in Year 0
Decision
100
Decision
Made in
Year 0
-106.5
Do Not
Invest
65
-115
-6.5
Present Value of
Cash Flows*
Since the decision to

invest was made in Year 0,
we are bound into a
negative NPV project in the
unfavorable state
Present Value of
Investments**
NPV
* [(0.5) (170) + (0.5) (65)] / 1.175 = 100

** 115 / 1.08 = 106.48: The investment is discounted at the risk-free rate because the decision to invest was made in Year 0
65
Real Option Analysis Flexibility Valued (cont.)

The ROA approach values the total project, with flexibility, at $20.95 ($2.54 less than the
DTA value). Since the ROA method is calculated using replicating portfolios, this must be
the correct value otherwise there would be arbitrage opportunities
Year 0
Year 1
CFs Replicated Using Replicating
Net
N Shares of Twin
Portfolio in
CFs* Security and Borrowing
Year 0
55
Decision
Deferred
Until
Year 1
Value of N shares @
$34 / share
Value of loan (B)

34N+B(1+rf)=55
Value of N shares @
$13 / Share
Value of loan(B)
13N+B(1+rf )=0
Value in Year 0
Buy 2.62
shares @
$20 /
share
27.4
Decision
20.9
Invest;
Based on
Flexibility
Value
Borrow
$31.43
Value =
20.95
-6.5
NPV**
* To see derivation of this column see Decision Tree Analysis chart

** See NPV / DCF valuation
Total value less NPV; this could be valued separately
2.62 shares X $20 / share -$31.43 = $20.95
66
Flexibility
Value
Total Value
Real Option Analysis Flexibility Valued

Rather than searching for a fictitious twin security we use the present value of the project
itself, without flexibility, as the underlying risky asset. What is better correlated with the
project that the project itself? We call this the Marketed Asset Disclaimer (MAD)
Year 0
Net
CFs*
55
Decision
Deferred
Until
Year 1
Year 1
CFs Replicated Using
N Shares of PV Type
(without flexibility)
and Borrowing
Value of N shares @
$170 share
Value of loan (B)

170N+B(1+rf)=55
Value of N shares @
$65 / Share
Value of loan(B)
65N+B(1+rf )=0
Replicating
Portfolio in
Year 0
Buy
0.524
shares
@ $100 /
share
Borrow
$31.53
Value in Year 0
27.4
Decision
20.9
Invest;
Based on
Flexibility
Value
Value =
20.95
-6.5
NPV**
* To see derivation of this column see Decision Tree Analysis chart

** See NPV / DCF valuation
Total value less NPV; this could be valued separately
0.52 shares X $100 / share -$31.42 = $20.95
67
Flexibility
Value
Total Value
Marketed Asset Disclaimer Assumption

Both the replicating portfolio approach and the risk-adjusted method (as we will apply them
in this section) rely heavily on the Marketed Asset Disclaimer assumption
Both the replicated portfolio approach and the risk-adjusted method rely on our ability
to buy shares of the base case present value (without flexibility) when creating the
replicating portfolios. If the present value is traded (as in the case of a stock) this will
not be a problem; however when the present value is not explicitly traded (as will
usually be the case with real options) our ability to build the replicating portfolio
becomes dubious
The Marketed Asset Disclaimer assumption implies that we assume that even if the
base case present value is not marketed we can still build the replicating portfolios,
because if it were marketed, the value we calculated (with our DCF model) would be
approximately equal to the publicly traded market value (if it existed); therefore the
replicating portfolio approach (and equivalently the risk-adjusted method) would still
produce the correct value
There are other approaches in the academic literature, however, noted academics
Steve Ross and Eduardo Schwartz support the Marketed Asset Disclaimer method
68
The Correct Cost of Capital

The cost of capital, as calculated from correct ROA value is 31.9%. Since this differs from
the original cost of capital for the project without flexibility (17.5%), flexibility has therefore
altered the projects riskiness
Year 0
Cost of Capital
Year 1
Net CFs*
20.9 = (0.5)(55)+(0.5)(0)
1+k
55
k = 31.9%
Value
20.9
The original cost of capital

was 17.5%
0
* To see derivation this column see Decision Tree Analysis chart

69
Step 3 Decision Trees

Initial Conditions (No Flexibility) Event Tree for Underlying Asset
Assumptions
Risk-free rate of 5%
WACC of 12%
Initial investment of $105MM
Five year time frame (analyzing one period
per year)
Underlying Asset
A factory with a (no flexibility) present value of
$100MM
The standard deviation of the rate of change of the
factory value (volatility) is 15%
No Flexibility (NPV)
($5MM) = $100MM $105MM
212
182
157
135
116
Value =
100
Investment = -105
NPV
-5
157
135
116
100
86
Value-based
Event Tree
116
100
86
74
86
74
64
64
55
47
t=0
t=1
t=2
t=3
70
t=4
t=5
Step 3: Real Options Calculations Examples

Option to Expand
Management has the right to expand the scale and the value of the factory by 20% at any
point in time by investing an additional $15MM
= Decision to Expand
239
204
175
173
149
127
108
148
126
124
107
91
106
90
88
77
75
65
64
55
47
t=0
t=1
t=2
t=3
t=4
t=5
Underlying Asset Values

PV+ = 86
PV- = 64
PV = 74
Managerial Decisions (t=4,5)
88 = Max (86, 86*1.2-15)
64 = Max (64, 64*1.2-15)
75 = Max (75, 74*1.2-15)
Portfolio Replication
n = (88 - 64) / (86 - 64)
B = [88 - n (86) ] / (1+5%)
n = 1.1, B = -5.54
Value of Option (ROA at t=4)
ROA = n (74) + B
ROA = 75
Note: In this case management will never exercise its option prior to the five year expiration date. In general, a call option on a non-dividend paying asset
will never be exercised early
71

Option to Abandon
At any point in time management has the option to abandon the factory. Abandonment
will yield a salvage value of $100MM
= Decision to Abandon
212
182
157
157
135
118
106
135
118
116
106
100
105
100
100
100
100
100
100
t=1
t=2

116 = Max (116, 100)
86 = Max (86, 100)
105 = Max (105, 100)
100
100
t=0

PV+ = 116
PV- = 86
PV = 100
t=3
t=4
72
t=5
n = (116 - 100) / (116 - 86)
B = [116 - n (116) ] / (1+5%)
n = 0.5, B = 51.5
ROA = n (100) + B
ROA = 105

Option to Contract
At any point in time management has the option to decrease the scale and the value of the
factory by 25%, generating savings of $25MM
= Decision to Contract
212
182
157
157
135
117
102
135
117
116
101
90
101
90
90
81
81
73
73
66
60
t=0
t=1
t=2
t=3
t=4
73
t=5

PV+ = 116
PV- = 86
PV = 100
116 = Max (116, 116*0.75+25)
90 = Max (86, 86*0.75+25)
101 = Max (101, 100*0.75+25)
n = (116 - 90) / (116 - 86)
B = [116 - n (116) ] / (1+5%)
n = 0.87, B = 14.4
ROA = n (100) + B
ROA = 101

Option to Expand, Contract or Abandon
At any point in time management has several options available:
Expand the scale and the value of the factory by 20% by investing an additional $15MM
Decrease the scale and the value of the factory by 25%, generating savings of $25MM
Abandon the factory with a salvage value of $100MM
= Decision to Contract
= Decision to Abandon
239
204
= Decision to Expand
175
173
150
129
113
148
127
124
112
102
110
101
100
100
100
100
100
100
100
t=0
t=1
t=2
t=3
t=4
74
t=5

PV+ = 116
PV- = 86
PV = 100
124 = Max (116, 116*0.75+25,
116*1.2-15, 100)
100 = Max (86, 86*0.75+25,
86*1.2-15, 100 )
110 = Max (110, 100*0.75+25,
100*1.2-15, 100)
n = (124 - 100) / (116 - 86)
B = [124 - n (116) ] / (1+5%)
n = 0.8, B = 29.7
ROA = n (100) + B
ROA = 110
Step 2 Modeling Uncertainties and Building the Event Tree

For the time being, assume that the uncertainties all move continuously through time and
remember that the annualized volatility (we need to calculate is the volatility of the percent
value which is usually hard to observe. Several factors combine to convert the uncertainty
of the real market prices, quantities, and costs that feed into the company to the equity
uncertainty that is manifested in the financial markets
Real
Markets
Data
Quantity
Cost
Financial Leverage
Diversification
Price
Operating Leverage
Financial
Markets
Data
Project Uncertainties
Equity
Uncertainty
Asset Uncertainties
Not directly observable
75
The base-case present value without flexibility for the investment is estimated a thousand
times to generate the standard deviation of the rate of return
Monte Carlo
Random Number
Generator
Valuation Inputs
Revenue growth rates
Margin assumptions
Capital expenditures
Net present value

for the investment
Valuation Model
DCF
V
n 1 = r
V0
s based on r
U = es
d=
76
1
U
Calculating Volatility Direct From Historic Market Data

If we have historical market data we can calculate the volatility of present value directly
Get Time Series

Data
Date
Value
Compute
Growth
Rate
Growth
Rate
Annualize
Transform
into Natural
Logs
Calculate
Variance
LN (Growth
Rate)
Example: Jan 89:
Feb 89:
G1=4/2
Ln4-ln2= .69
Mar 89:
G2=3/4
Ln3-ln4= -.29
April 89:
G3=5/3
Ln5-ln3= .51
Variance
.27
(var
t)
Convert
into
Volatility (v)
SQRT (VAR)
Annualize
Volatility
.27
= 3.26
1/12
SQRT (3.26) = 1.81
Comments:
t is based on the time series data; in this example t = 1/12 since the data is monthly
Once we know the annualized volatility, we can use a different t in the building the tree
77
Calculating Volatility from Management Estimates

What is the 95% confidence level in year 5?
100
Expected
20
p lower
ri
Po
s=
2
r
P6 = Po e
r=
P
l
n 6
Po
78
Keeping Uncertainties Separate

When technological uncertainty evolves discontinuously and other uncertainties evolve
continuously, we use a quadrarial approach
Tech
Good
Tech
Good
Tech
Average
Market Up
Market Down
Tech
Bad
Market Up
Tech
Bad
Market Down
Market Up
Market Down
Market Up
Market Up
Market Down
Market Down
79
Portes Case Situation

1. Portes founded 10 years ago, 60 employees, CEO Diane Mullins
2. Slow growth of profitable systems recovery product, Recovery
3. New high-end data recovery software can be sold over the Internet
4. Bill, the CFO, finds that selling in France The Portes Project via the Internet, has a negative NPV. Monte Carlo analysis
doesnt help [see table 1 for the analysis]
Sales of 200 programs in year 1, doubles to 400 in 5 years
Unit price starts at $30,000 and falls to $20,000 in 5 years
COGS is $9,000 per program in year 1 and falls to $7,000 in 6th year
Fixed cost $20,000 per year
SG&A? is 10% of revenue
Initial investment is $35 million, depreciated over 10 years
No debt
40% tax rate
13% cost of capital
Beyond year 10, FCF grows at 4%, and ROIC 12%
5. Risk estimates, in 6th year
Unit sales, expected level is 400 programs and the lower 95% confidence limit is 190
Unit price, expected level is $20,000 and the lower 95% confidence limit is $25,000
6. Flexibility in decision-making
Expansion (prevent loss product), invest $10.5 million and increase value 30%
Abandonment value is $15 million
80
Table 1
NPV Analysis of the Investment Proposal
Item
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Quantity (units)
Continuous Annual Growth Rate
200
13.9%
230
264
303
348
400
Price per unit

Continuous Annual Growth Rate
30.00
-8.1%
27.66
25.51
23.52
21.69
20.00
9.0
8.6
8.1
7.7
7.4
7.0
Revenues
Cost of Goods Sold
6,000
1,800
6,355
1,966
6,732
2,148
7,130
2,346
7,553
2,563
8,000
2,800
Gross Income
Gross Margin%
4,200
70%
4,389
69%
4,584
68%
4,784
67%
4,990
66%
5,200
65%
200
600
200
636
200
673
200
713
200
755
200
800
EBITDA
3,400
3,554
3,711
3,871
4,034
4,200
Depreciation
3,500
3,500
3,500
3,500
3,500
3,500
54
-154%
211
294%
371
76%
534
44%
700
31%
21
84
148
214
280
32
126
223
321
420
3,500
3,500
3,500
3,500
3,500
3,500
3,400
3,532
4%
3,626
3%
3,723
3%
3,821
3%
3,920
3%
Cost per unit
Rent
S&A expenses
EBIT
EBIT Growth
(100)
Taxes
Net Income
(100)
Depreciation
Initial Investment
Free Cash Flow
Change in FCF
35,000
(35,000)
Continuous Value
Discount Rate
PV
TPV
FCF as a % of PV
Year 7
50,960
13%
34,681
(319)
36,096
39,496
8.6%
37,575
41,107
8.6%
39,165
42,792
8.5%
81
40,880
44,603
8.3%
42,735
46,555
8.2%
44,748
48,668
8.05%
Outputs of the Initial NPV Analysis

The free cash flow of the project has the usual profile with a significant initial investment
followed by a small positive cash inflows and a considerable terminal value
Free Cash Flows
60
50
Continuous Value
Investment
40
Depreciation
30
Net Income
20
Dollars
($ 000)
10
0
-10
-20
-30
-40
1
Year
82
Inputs for the Monte Carlo Simulation: Price per Unit

We will obtain the management estimate of the price volatilities indirectly by asking them:
"In the NPV analysis we expect the price at year six to be 20. We all understand that this
is an average estimate. We need to ascertain, with 95% confidence, your estimate of how
low the actual price can fall at year six."
We assume that the sales will

follow a Geometric Brownian
Process
Price Uncertainty Range (95% confidence interval)

40
P6 = P1eTr = 30e5(8.11%) = 20
31.5
Using the floor estimate for the

year six we can find the annual
price volatility and use it in the
Monte Carlo simulation
30
30
30.6
29.4
28.1
30
30.0
$ Price
per Unit
PTlower
ri Ln P
=
0
s= i1
2 T
15
5 * (8.1%) Ln
30 = 6.43%
s=
2 5
20
Expected Price
Upper Range
25.3
23.3
21.4
21.3
D
18.8
Lower Range
20.0
16.8
15.0
10
1
Year
Minimum Price per unit in year 6

With 95% Confidence
C
26.7
27.6
24.3
n
83
15
Inputs for the Monte Carlo Simulation: Units Sold

To obtain management's estimate of the sale quantity volatility we ask a similar question:
"Given that the expected average sales for year six is 400, what is the level where we can
expect with 95% confidence that the actual sales will be higher?"
We assume that the sales will

follow a Geometric Brownian
Process
Q6 = Q1e = 200e
Tr
= 400
5*13.86
Units Sold: Uncertainty Range (95% confidence interval)

900
842.1
800
677.7
700
Using the floor estimate for the

year six we can find the annual
sales volatility and use it in the
Monte Carlo simulation
Number 500
of Units 400
300
P
ri Ln P
=
0
s= i1
2 T
n
lower
T
539.6
600
Up Range
Low Range
400
348
200
200
229
264
164.7
164.8
300
170.3
178.9
190.0
0
1
190
5 *13.86 Ln
200
s=
= 16.65
2 5
320.5
200
100
Expected Quantity
422.6
Year
Minimum Sales Quantity in year 6

With 95% Confidence
84
190
Output of the Monte Carlo Simulation: Volatility of the Projects Value

Now we can complete the whole Monte Carlo simulation, and run the uncertainties through
the NPV model to get an estimate for the volatility of the project's value.
For 1000 trials the distribution of the rate of return approximates normal distribution with a
mean value of 12%. The volatility (standard deviation) of the rate of return is 30%
Fo recast: Expected Ann ual Return

1,000 Trials
4 Ou tliers
.03 5
35
.02 6
26 .25
.01 8
17 .5
.00 9
8.7 5
.00 0
0
-7 5%
Frequen cy Ch art
-3 1%
13 %
85
56 %
10 0%
Event Tree for the Present Value of the Project Without Flexibility
Having combined management estimates of uncertainty about price and quantity into a
single uncertainty of the value of the project, we can build a value-based event tree.
Adding back the initial $35 million investment yields the present value of the project at
node A, namely $34.681 million
PV Uncertainty Tree
PV Uncertainty Tree
$120,000
113,865
104,694
Expected Present Value
$100,000
K
91,895
84,354
$80,000
74,277
68,077
$60,000
62,491
60,120
C
A
$40,000
34,681
57,457
50,433
46,294
48,725
44,538
B
39,496
36,096
55,025
40,764
37,362
32,995
30,199
M
27,678
25,407
26,741
24,443
$20,000
22,372
20,505
18,108
16,573
N15,190
13,944
12,278
11,253
34,296
31,533
H
I
18,822
17,306
10,330
9,498
5,669
5,212
8,337
7,652
$0
(319)
44,748
-$20,000
We have assumed that uncertainty evolves from year 1. Alternately, one

could assume that it starts immediately and that there are two branches rather
than one.
86
Free Cash Flows Corresponding to the Project without Flexibility

From the event tree we can derive the possible Free Cash Flows for each of the scenarios
the project may follow
Free Cash Flow
Free Cash Flow

10000
9,171
9000
8000
7,541
7000
6,199
6000
5,095
$ 5000
5,033
4,187
4000
4,139
3,402
3,400
3000
2,796
2,762
2,298
2,271
2000
1,867
1,535
1,516
1,247
1,025
1000
832
457
684
0
0
Year
87
Real Option to Expand
Option to Expand
Illustrative
Description: Introduction of the new

product PreventLoss to the French market
Time-horizon: Within the next six years
Benefit: Increase the operations and the

present value by 30%
Additional Investment: Estimated at

$10.5 million
Optimal Execution: The expansion

should take place only if the increase of
the projects present value is larger than
the expected additional investment
Present
Value
$MM
Year 2000
Cash
Flow
88
Real Option to Abandon
Option to Abandon
Description: Opportunity to stop baring

additional losses and close the operation
Time-horizon: Within the next six years
Benefit: Stop a negative cash flow and

re-deploy resources. Sell the hardware for
$15 million
Additional Investment: Closing of the

French operation and redirecting the
resources is not expected to require
additional investment
Optimal Execution: The operation should

be abandon when its present value turns
below $15 million
Illustrative
$MM
Present
Value
Year 2000
Cash
Flow
89
Real Options Calculations for a Final Node of the Event Tree

We start at the end of the tree and analyze the optimal execution of the two options at
each final node
42,121
38,721
52,270
48,083
28,684
26,386
66,128
61,033
34,349
31,553
20,866
19,332
84,200
78,001
42,407
39,005
23,568
21,701
16,949
15,924
106,701
99,160
53,821
49,682
27,678
25,407
17,756
16,510
15,684
15,000
134,774
125,602
69,228
64,194
34,296
31,533
18,822
17,306
15,832
15,000
15,457
15,000
90
Real Options Calculations for a Final Node of the Event Tree (cont.)
The replication process starts from the end of the PV tree and moves backwards
The maximum value of the project after paying out free cash flow is the maximum of its intrinsic value and
the values of the expansion or abandonment options
MaxValue = Max104 ,694 / 104 ,694 * (1 30 %) 10 ,500 / 15,000

125 ,602 = Max(104 ,694 / 125 ,602 / 15,000 )
The total PV of a project at this point is the maximum present value plus the free cash flow
134,774 = 125,602 9,172
91
Real Options Calculations for an Intermediary Node of the Event Tree

After we have identified the Real Options Values at the final nodes, we move backwards a
period and repeat the same procedures
42,121
38,721
52,270
48,083
28,684
26,386
84,200
78,001
66,128
61,033
42,407
39,005
34,349
31,553
23,568
21,701
20,866
19,332
16,949
15,924
106,701
99,160
53,821
49,682
27,678
25,407
17,756
16,510
15,684
15,000
134,774
125,602
69,228
64,194
34,296
31,533
18,822
17,306
15,832
15,000
15,457
15,000
92
Real Options Calculations for An Intermediary Node of the Event Tree

(cont.)
First we have to find the replication value for the node
n=(134,774-69,228)/(113,865-62,491)=1.276
B=(134,774-1.276*113,865)e-.05 =-9,988
ROV = 1.276*84,354-9,988 =97,633
The maximum value of the project after paying out free cash flow is the maximum of its intrinsic value and
the values of the expansion or abandonment options
MaxValue = Max97 ,633 / 84 ,354 * (1 30 %) 10 ,500 / 15,000

99 ,160 = Max(97 ,633 / 99 ,160 / 15,000 )
The total PV of a project at this point is the maximum present value plus the free cash flow
106,701 = 99,160 7,541
93
Outputs from the Real Options Analysis: Optimal Execution

Both the option to expand and the option to abandon add to the flexibility of the project as
they will be executed in many possible scenarios
As can be expected, the option to expand will be optimally executed if the project does well
and the option to abandon if it does badly
Expand
OPTIMAL REAL OPTION EXECUTION
Expand
Expand
Expand
Expand
Expand
Go
Go
Go
Go
Go
Go
Go
Go
Go
Go
Go
Go
Abandon
Abandon
Abandon
Year
94
Outputs from the Real Options Analysis: Projects Value with Flexibility
Because of the projects high level of uncertainty, the flexibility has added a significant
value to its NPV
By enhancing the projects upside in case of success, and bounding the down side in case
of failure, the options have moved its net present value from negative $319,000 to positive
$1,986,000
ROA vs. NPV
ROV
No Follow-up
($500)
$1,986
($319)
$0
$500
$1,000
$1,500
$2,000
$2,500
95
Insights
1. NPV requires mutually exclusive alternatives, ROA does not. For example consider a deferral option
NPV Mutually Exclusive Alternatives
MAX0
NPV0
Start immediately
NPV1
Defer one year
ROA Decision Tree

Invest
Defer
Defer
NPV2 Defer two years

.
.
.
NPVN Defer N years
MAX0 E [NPVt] = NPV
Invest
Defer
Defer
Defer
Invest
Defer
Abandon
<
ROA=E [MAXt NPVt]
The value with flexibility is always greater than the value without. Furthermore, The ROA results yield
decision rules regarding what action to take in each future state of nature
2. Capital spending should be evaluated as a program rather than one project at a time. If we are evaluating a CAPEX
program; we should take into account a variety of flexibilities
Excess capacity vs. inventories
Economics of scale vs. smaller plants more geographically diverse
96
Issues
Much remains to be done
1. Game theory and real options
2. Path dependent solutions

3. More than two discontinuous sources of uncertainty
97

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Trends in Valuation

NIVRA, Amsterdam, June 1, 2001

For more reading see:

Copyright 2001 by Monitor Company Group, L.P.

Changes in Value are at the Heart of Economic Decision-Making

Real Options Analysis

Copyright 2001 Monitor Company Group LP Confidential CAM

Discounted Cash Flow Definition

DCF has three components:

EBIT - Cash taxes on EBIT + accrued taxes due

EBIT (1 cash tax rate)(1 g / r )

Copyright 2001 Monitor Company Group LP Confidential CAM

DCF Works Well For Large Publicly Held Companies

35 Large U.S. Companies, 1988

1999 Market / Book Value

1988 Market / Book

31 Large U.S. Companies, 1999

1988 DCF / Book

1999 DCF / Book Value

Source: Value Line Forecasts, Monitor Analysis

High Correlation Between Market Value and DCF Value

DCF / Book (Using Value Line Forecasts)

Copyright 2001 Monitor Company Group LP Confidential CAM

Correlation between DCF and Market Value Italy

Correlation Between DCF and Market

* Using publicly available information

Copyright 2001 Monitor Company Group LP Confidential CAM

DCF Works Across Different Industries

Market / Book Value

DCF / Book Value

* 5 banks are non-U.S. banks

Copyright 2001 Monitor Company Group LP Confidential CAM

1999 Trading Volume (AOL)

DCF Works for Robust Growth Companies

Note: 1999 elsewhere in valuation refers to FY 99 which ends in June

Copyright 2001 Monitor Company Group LP Confidential CAM

* Most analysts did not forecast beyond 2003

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL Projected Operating Margins Benefit From Both Significant Scale

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL: Increasing Capital Productivity

Capital Expenditures and Capital Turns (Rev / Invested Capital)

* Most analysts did not forecast beyond 2003

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL: Matures Led to the Use of a Changing WACC

AOL Capital Structure

Source: Compustat, Bloomberg, Monitor Analysis

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL: Continuing Value

Return on New Investment

WACC = 11% in the long run

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL: Metcalfs Law (Interconnectivity) Makes Scale a Sustainable

AOL has 18 million customers 1.62 x 1014 connections

AOL has roughly 10 times as many customers as MSN,

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL: The Changing WACC and Continuing Value Assumptions Bridge

AOL Entity and Equity Value

$93 per Share

Copyright 2001 Monitor Company Group LP Confidential CAM

AOL Market Ratios Decline Over Time as the Firm Matures

Price to Earning and Price to Book

Copyright 2001 Monitor Company Group LP Confidential CAM